12/14/2010 @ 2:00PM

Whistle-Blowing Is The Best Way To Fight Corporate Fraud

“For Whistle-Blowers, Expanded Incentives,” declared a New York Times headline on Nov. 15. Until now, the article noted, it has been left to regulators to decide how much to pay corporate insiders for providing them with evidence of corporate wrongdoing. Under this system, total whistle-blower payments over the past two decades have come to a total of just $160,000.

Under the new Investor Protection Act, by contrast, a whistle-blower compensation fund has already been funded to the tune of $475 million.

With this substantial sum waiting to be disbursed at the discretion of the Securities and Exchange Commission, it’s not hard to imagine that whistle-blowing will become an increasingly popular alternative in the coming years. Even without large financial incentives, over 90% of the SEC’s enforcement actions over the years have started with whistle-blower tips.

It comes as little surprise that the corporate sector, whose leaders stand to be accused of wrongdoing, have launched an aggressive counter-attack against the new legislation. Corporate executives are frightened for good reason. Many have used manipulation and fraud to amass large personal fortunes. They come at the expense of rank-and-file shareholders, whose returns have been near zero over the past decade. The execs who have paid lip service to compliance and risk management while dipping into shareholders’ coffers will fight tooth-and-nail against any tipster incentives.

Coming to their defense in the Times story is Harvey Pitt, the former SEC chairman who is now chief executive of Kalorama Partners, a corporate advisory firm. “Compliance departments [inside companies] will now be competing with the SEC for who gets the tip first,” warns Pitt in the Times article.

To me, this remark makes no sense. Is it really likely, as Pitt suggests, that corporate compliance departments will rat out their own executives? Should we continue to rely on them to act as anti-fraud monitors and keep an eye on their own executives–a task they have proven incapable of performing? It seems more likely to me that Pitt is creating a smoke screen to undermine the importance of publicly funded whistle-blower incentives as a form of investor protection.

The Sarbanes-Oxley Act of 2002 was aimed at reducing malfeasance and fraud by corporate managers. In the years since its implementation, however, there has been no decline in corporate fraud, as evidenced by the number of regulatory enforcement actions, shareholder lawsuits, abrupt price drops and earnings restatements. We created Audit Integrity in 2002 in the hope that, by creating forensic tools that can handicap the likelihood of such negative events, we could change the corporate culture and eventually put ourselves out of business. That’s yet to happen.

Clearly, corporate America is the most powerful influence on government policy today. One can only hope that initiatives like the Investor Protection Act will hold up against its extreme pressure and will itself be protected by our legislators and regulators.

James Kaplan is cofounder and chairman of Audit Integrity, now part of GovernanceMetrics International.